Question

The Detroit housing sector consists of three submarkets, high quality, medium quality and low quality. Assume at first that all three submarkets have perfectly inelastic supply curves.

a. Draw supply and demand diagrams for each submarket.

b. The demand curve in the middle submarket now shifts down as the result of the outmigration of middle class households to the suburbs. Keeping supply curves perfectly inelastic, draw new supply and demand diagrams showing the new equilibrium positions in each submarket. Explain the changes in equilibrium illustrated in these new figures.  

c. Explain why the assumption of perfect inelasticity in the low-quality market may be unreasonable. Make clear what assumption might be more reasonable. Redraw the initial supply-demand curves for the low quality market under the new assumption.

Answer 1

(a) In following graph, Panel H shows the market for high-quality housing, Panel M shows the market for Medium-quality housing and Panel L shows the market for Low-quality housing. In each market, Price of housing (P) and quantity of housing (Q) are measured vertically and horizontally respectively. In each market, D0 & S0 are initial demand & supply curves (with vertical supply curve reflecting perfectly inelastic supply), intersecting at initial equilibrium point A with initial equilibrium price P0 and quantity Q0.

(b) In panel M, the outmigration will decrease demand, shifting demand curve to left, from D0 to D1, reducing price from P0 to P1 but number of housing will remain unchanged at Q0. In other two sub-markets, the outmigration will increase demand for housing in the respective markets, shifting D0 toward right to D1, intersecting S0 at point B with higher price P1 and quantity being the same at Q0.

(c) The assumption of perfectly inelastic supply in Low-quality sub-market is most likely unreasonable because, if there is higher demand for Low-quality housing, price of low-quality housing will increase (caused by a rightward shift in demand curve) and rational suppliers will react to this higher price by increasing the number of housing supplied. Therefore the supply curve will be upward rising in conformance with the law of supply. In following graph, D0 & S0 are initial demand & supply curves (with S0 being upward sloping) intersecting at point A with initial price P0 and quantity Q0.